How venture capital works . . .

March 11, 1985

Venture capitalists invest in new or growing companies at several stages, ranging from start-up to expansion. They put in money and, in return, receive an ownership position and usually a spot on the board of directors. The money comes from private funds. The kind discussed here comes largely from wealthy investors, corporations, pension funds, and other institutions. These funds usually operate as limited partnerships, with investors supplying the money as limited partners and a few individuals managing the money as general partners.

For entrepreneurs, venture capitalists can be a mixed blessing. The company often receives more money than a bank would lend and does not face the added burden of debt service. The entrepreneur, however, loses part of his company to the money men. They sometimes take a deliberate and heavy hand in operations to protect their investment.

The venture investor wants companies with the potential for making barrels of money. Xerox was venture financed; so was Federal Express; but so was Osborne Computer and a lot of others that whirled off into bankrupt obscurity.

A venture capitalist usually expects two-thirds of the companies in his portfolio to lose some or all of the invested money. Another one-third should make money: from two to five times the size of the investment. One out of 15 or so should pop a grand slam, putting the entire portfolio ahead.

Primary-stage financing is the one most associated with venture capitalists. It provides seed money to companies that are often no more than a product idea and a business plan, the sort of thing worked out on the back of a restaurant napkin.

Going public: A venture capitalist will also sink money into a company so it can expand or to bridge the company to a public stock offering or acquisition. The latter two events give venture capitalists their door out of the company and into a tidy profit -- theoretically.

It's the public-offering part that has given venture capitalists so much trouble over the past year. When a portfolio company is ready to go public, it sells stock in the new-issues segment of the stock market.

Wall Street refers to such issues as IPOs (initial public offerings). Venture capitalists receive shares of common stock from the IPO in proportion to their ownership percentage. But they can't turn that stock into cash. The federal government requires that owners of an IPO company keep that stock for two years.

It is termed 144 stock, for the regulation it falls under. In 1983 the IPO market was hot, and a lot of venture capitalists took their companies public -- sometimes before they were ready -- to tap stock buyers willing to pay high prices. But the whole market, IPOs included, retreated in mid-1983 and into '84, giving many venture funds hefty, unrealized paper losses on their holdings.

An IPO that sold for $20 in July of 1983 might now be selling for $12. A Venture Capital Journal index of 100 publicly traded companies that were venture financed has acted more like a handful of hot potatoes than hot stocks, dropping 45 percent from November 1983 to December '84.

In other instances, the market soured before the venture funds could even get their portfolio companies to the public block. Since needed financing did not come from public investors, it again had to come from the venture investors.